Don’t get caught performance chasing; past performance is no guarantee of future results. – Written (but rarely heeded) on every prospectus
The first thing an investor looks for when selecting a fund is how well the fund has performed over time. Many novice investors stop there and don’t look at any other criteria. This is about the time when Benjamin Graham rolls in his grave until he burns a hole in the bottom of his coffin. If the investor uses a screener, the first filter they adjust is to screen for the top performing funds over the last year, 3 years, 5 years, 10 years, etc. This makes sense, right? At first thought, it seems obvious that the best fund will be the one that has performed the best in those rolling time periods. However, this is simply not the case.
Consider a fund that has a heavy weighting in a particular stock. If this stock happens to perform very well one year, the fund that holds the stock will be one of the best performers in its class and rank highly among its peers. It could likely get a 5-star Morningstar rating (which, by the way, has proven not to be a good predictor of future performance). When the fund has a stellar 1-year record, that 1 year will favorably affect the 3-year, 5-year and 10-year performance as well. So, it may appear to have performed very well over a long-time period, when in fact, it only had one great year.
Also, funds that have performed well in a given year can imprudently overweight a particular stock, bond or industry. That is why extra layers of due diligence beyond performance are required to achieve long-term investment success. There are several qualities that a well-managed fund must possess to be successful in the long term.
I will address good fund qualities in a future blog. For today though, I would like to focus on the dangers of performance chasing. Performance chasing is when an investor buys the stock, mutual fund, bond, etc. that has recently performed the best, and when that asset inevitably declines in performance, the investor sells and buys the next best thing. Quite frankly, it happens often in the financial advisory industry, too. A client complains that XYZ fund is down, and the advisor sells it to buy the best performing fund on the market. An advisor may also try to win new clients by building them a portfolio of funds that performed best over the last 10 years.
To quantify the dangers of this practice, a large fund manager performed a study a few years ago. In each equity asset class (Large Cap Growth, Large Cap Value, Mid Cap Growth, etc.), they simulated the two strategies: buy and hold versus performance chasing. In the buy and hold strategy, they simply bought all funds in the asset class and held for 10 years. If a fund was discontinued, they reinvested the proceeds in the median-performing fund. In the performance chasing strategy, they bought all funds that had above median performance for a 3-year period. If a fund dropped below median performance, they sold and immediately reinvested in above median performing funds.
As you can see in the table below the winner in every equity style box is clearly the buy and hold strategy by a wide margin.
Just think if you would have taken this a step further and applied time-tested manager selection criteria to select funds instead of simply buying everything. You may have likely outperformed your performance chasing peers by an even wider margin than this study. So next time your performance chasing buddies are talking about the next hottest investment idea, you can rest assured knowing that performance is just one of the many criteria to consider when investing.
Please feel free to contact me if you would like to discuss what we are investing in at HighTower Twickenham and what makes sense for your financial objectives.
JGibson@HighTowerAdvisors.com | 256.213.1150
HighTower Twickenham is registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.
This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors.
All data and information reference herein are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary, it does not constitute investment advice. The team and HighTower shall not in any way be liable for claims, and make no expressed or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice.
This document was created for informational purposes only; the opinions expressed are solely those of the team and do not represent those of HighTower Advisors, LLC, or any of its affiliates.